Well-Timed Bet Means GE Dominates Caterpillar in Locomotives

As rain pelted the windows at General Electric Co. offices in Chicago, executives debated whether to build a low-emission locomotive. The deliberations went on for two days, and to keep the mood upbeat anyone with a negative comment had to toss cash into a jar on the table.

Though predictions were for anemic demand, the team voted to press ahead and spend $200 million to develop the engine. The decision in April 2013 turned out to be pivotal, not only for GE. Caterpillar Inc. took industry forecasters at their word and may not have a model meeting the U.S. pollution standards that kick in Jan. 1 until 2017. GE’s will be ready next year.

That gives GE a lock on sales to U.S. railroads, the biggest buyers in a $2.5 billion North American market, at just the right time. Their fleet spending is taking off to meet a boom in consumer demand, surging crude-oil shipments and the hangover of a record 2013 grain crop.

“The market happened to turn — we placed a strategic bet to be here should it turn and it happened to turn,” Russell Stokes, chief executive officer of GE’s transportation unit, said in an interview. “We’re clearly seeing indicators that it’s going to be a good 2015 for the railroads.”

The wager secures GE’s spot for at least a few years as the world’s largest locomotive maker, and sets Caterpillar back in its goal of grabbing enough market share to be a closer No. 2.

As recently as four months ago, GE didn’t have a single order for the new model. Then Union Pacific Corp. and other carriers changed plans, faced with volumes causing gridlock on some tracks. Now 1,000 orders have poured in, according to GE, which doesn’t identify buyers. That could bring in $3 billion in revenue to the transportation unit over the next three years.

Demand Surprise

The demand surprised Caterpillar, which had figured the market for new engines would be “hardly any at all” in 2015 and 2016, said Michael DeWalt, vice president for strategic services, at a Citigroup Inc. conference on Sept. 23. “Well, that situation changed around a little bit.”

Caterpillar, which acquired engine manufacturer Electro- Motive Diesel four years ago, had scrapped the new-model program that was on the boards at EMD after concluding railroads would hold off on purchases.

“We didn’t really like what we saw in terms of the end product with that engine,” Caterpillar CEO Doug Oberhelman told analysts on a July conference call. DeWalt said the company expects its low-emission model will be ready in 2017.

GE shares fell 0.8 percent to $25.42 at the close in New York, while Caterpillar dropped 0.5 percent to $99.83. The Standard & Poor’s 500 Index dropped 0.3 percent.

Freight locomotives use diesel engines to produce electricity for the motors that turn the wheels. Since 1998, manufacturers have been through periodic updates -- this is the fourth, called Tier 4 — to meet anti-pollution rules.

Toughest Upgrade

The reductions in this upgrade will account for 70 percent of the cuts required by the government. Exhaust gases will be recirculated back into the engine, a process that requires an enhanced cooling system.

“They saved the toughest for last,” said Tina Donikowski, chief of GE’s global locomotive unit, who was at the Chicago meeting, an annual planning session for the transport business.

The executives around the table needed to make a thumbs-up- or-down decision on the Tier 4 model, which meant committing $200 million to development, Donikowski said. Waiting any longer would have made a rules-compliant engine in 2015 impossible.

“It was a move that took a good amount of discussion and courage,” she said. The money collected in the jar was donated to charity; GE declined to say how much the negative commentators ended up throwing in.

Testing Prototypes

Carriers weren’t clamoring for a new locomotive when the GE team met 17 months ago. Union Pacific, for one, had expected to buy only 200 new engines this year and none in 2015, according to Chief Operating Officer Lance Fritz.

Then the boom didn’t slow down. Freight carloads jumped 7.1 percent in the second quarter, the most since late 2010. The stock rally continued too: The Standard & Poor’s 500 Railroads Index has outperformed the broader S&P 500 by almost sixfold.

“With the volume growth we’ve seen this year, it’s just going to force us to get in the market” in 2015, Fritz said. “We’re in the best of worlds right now in terms of lots of demand and trying to figure out how to handle it effectively.”

Union Pacific, which added 29 locomotives to its 2014 order, is studying Tier 4 purchases and testing five of the new locomotives’ prototypes, Fritz said.

BNSF Railway Co., the largest railroad by revenue, is buying 500 Tier 3 models this year as it fights the worst track congestion in the U.S. industry.

EPA Approval

At Fairfield, Connecticut-based GE, the transportation unit expects to sell 750 locomotives this year and is working with suppliers to increase output for 2015, Stokes said. It opened a new factory in Texas in January last year, and expects Tier 4 production to begin in the second half of next year. The Environmental Protection Agency has to approve the machine’s design.

The GE unit’s revenue was up 54 percent in the five years ended in 2013, reaching $5.89 billion. Caterpillar doesn’t break out results for its division but said in July that it’s more than doubled locomotive sales since the acquisition of EMD, which had 2009 revenue of $1.8 billion.

With companywide sales of almost $56 billion last year, Peoria, Illinois-based Caterpillar, the largest maker of construction and mining machinery, can afford to forgo U.S. new- locomotive sales for two years, said Andy Kaplowitz, a Barclays Plc analyst who has an overweight recommendation on the stock.

‘Intricate Recipe’

“They’re willing to absorb the drop in ’15 and ’16,” Kaplowitz said. “It’s worth it to make sure the engine is done correctly.”

The Tier 4 required a new motor design in what GE’s Donikowski called a “very, very intricate recipe.” The new six-axle locomotive will be four feet longer than Tier 3’s 68 feet. It will cost as much as 20 percent more than engines on the market now, Donikowski said. Those sell for about $2.5 million, according to railroad executives.

Caterpillar’s DeWalt said there’s no question that U.S. railroads “find themselves in a need for a bit more power” than most anyone in the industry had anticipated.

“They may end up buying more or at least want more than we thought they were going to need,” he said. “We’ll see how that plays out.”

An April 2013 decision by General Electric to develop a low-emission locomotive has put the company well ahead of competitor Caterpillar in producing a product that meets tighter federal pollution standards.